Lower E & P company borrowing capacity alters investor calculus

A recent Wood Mackenzie consultancy report argues that concerns over an impending credit crunch for US operators is exaggerated. This concern was initially raised by Moody’s, which predicted that lenders will lower their price decks by 15 – 25%.

Price decks are used by lenders to determine the value of company reserves and thus borrowing bases. They are commonly used in relation to reserves-based financing (RBF), which is a form of revolving credit based on the net present value of reserves, typically on a proved developed producing basis (PDP).

Wood Mackenzie’s claim is backed by a detailed examination of the financial health of 26 operators. Its two notable arguments are that 1) the larger producers in its coverage universe have sufficient liquidity to survive price deck redeterminations in the near-term and that 2) at least two-thirds of US production either has no RBF exposure or is not subject to redetermination until 2016.

The report’s conclusion is that the larger producers in its peer group can survive a borrowing base cut. This partially echoes the view of an earlier report which concluded that only a small subset of its 17 high-yield operator peer group lacked sufficient liquidity to weather the next 12 months.

Given the prolonged nature of the present downturn, uncertainty about bottom commodity prices, and little line of sight to recovery, it stands to reason that the presence of short-term liquidity is no guarantee of continued industry health over a longer window.

To be sure, the argument makes sense insofar as larger operators are concerned. After all, they have greater liquidity cushions, at least for the short-term. Additionally, larger operators have access to alternative forms of financing that are not necessarily impacted by price deck redeterminations.

On the other hand, smaller operators are particularly vulnerable, and while they comprise only a small part of overall production, their ultimate potential may be greater than their production profile indicates. Many smaller producers had growth programs before the downturn and in theory still form the basis for greater development of resource plays over the longer term.

Vulnerable producers certainly are logical takeover targets, but it is important to remember that an acquirer’s plans for new assets often differ from those of the prior owner. Consider that assets bought opportunistically on the cheap may not rank highly in allocation of scarce capital.

Additionally, since capital markets are in large part influenced by human psychology, redeterminations signal greater industry-wide vulnerability to the downturn. Equity issuances are increasingly rare and will likely become more so as investors factor in added liquidity risk. Additionally, investors have long memories, and the closer a company’s brush with disaster, the stronger the concerns about the adaptability and long-term viability of its model, regardless of commodity prices. It is important to remember that the consultancy report’s relatively optimistic conclusions are only applicable to the short-term.

Finally, like investors, actors in the political arena respond to market signals, and not always in the interests of the industry.

Internationally, this news will only embolden geopolitical competitors like Saudi Arabia in their current strategy to undermine US competitors, potentially delaying recovery as a result.

Domestically, certain politicians may make use of the industry’s deteriorating situation to push their partisan agendas or jockey for position, as exemplified by Alberta Premier Notley’s quixotic quest to completely wean the province off its reliance on oil & gas revenues and Hilary Clinton’s recently announced opposition to Keystone XL, respectively. While both these statements should be taken with a grain of salt, the industry is not in the best shape to handle potentially damaging posturing by ambitious politicians.

There is no dispute that the oil & gas industry has staying power and is riding out this downturn reasonably well. But sufficient time can overcome even the best defense. Given the precarious situation, bad news begets more bad news and the cascade effect of this could have far graver consequences than a single bad news item would suggest. It would not be prudent to assume that the buck stops with RBF price deck redeterminations.